assessing risk|realizing opportunities

The world is a great big database and algorithmic wizards and mad data scientists are burning the midnight oil to mine the perplexing infinities of ubiquitous data points. Their goal is to put data to use to facilitate better governance, initiate pinpoint marketing campaigns, pursue revelatory academic research and improve the quality of service public agencies deliver to protect and serve communities. The convergence of Big Data, Cloud Computing and the Internet of Things (IoT) make this possible.

The earth is the mother of all relational databases. It’s six billion inhabitants track many billions of real time digital footprints across the face of the globe each and every day. Some footprints are readily apparent and easy to see. Facebook likes, credit card transactions, name and address lists, urgent Tweets and public records sparkle like alluvial diamonds; all easily plucked by data aggregators and sold to product marketers at astonishing profit margins. Other data points are less apparent, hidden or derived in the incessant hum of the ever listening, ever recording global cybersphere. These are the digital touch points we knowingly and unknowingly create with our interactions with the world wide web and the machines that live there.

It is estimated that there is over 20 billion smart machines that are fully integrated into our lives. These machines stay busy creating digital footprints; adding quantitative context to the quality of the human condition. EZ Passes, RFID tags, cell phone records, location tracking, energy meters, odometers, auto dashboard idiot lights, self diagnostic fault tolerant machines, industrial process controls, seismographic, air and water quality apparatuses and the streaming CBOT digital blips flash the milliseconds of a day in the life of John Q. Public. Most sentient beings pay little notice, failing to consider that someone somewhere is planting the imprints of our daily lives in mammoth disk farms. The webmasters, data engineers and information scientists are collecting, collating, aggregating, scoring and analyzing these rich gardens of data to harvest an accurate psychographic portrait of modernity.

The IoT is the term coined to describe the new digital landscape we inhabit. The ubiquitous nature of the internet, the continued rationalization of the digital economy into the fabric of society and the absolute dependency of daily life upon it, require deep consideration how it impacts civil liberties, governance, cultural vibrancy and economic well being.

The IoT is the next step in the development of the digital economy. By 2025 it is estimated that IoT will drive $6 Trillion in global economic activity. This anoints data and information as the loam of the modern global economy; no less significant than the arrival of discrete manufacturing at the dawn of industrial capitalism.

The time may come when a case may be made that user generated data is a commodity and should be considered a public domain natural resource; but today it is the province of digirati shamans entrusted to interpret the Rosetta Stones, gleaning deep understanding of the current reality while deriving high probability predictive futures. IoT is one of the prevailing drivers of global social development.

SME

There is another critical economic and socio-political driver of the global economy. Small Mid-Sized Enterprises (SME) are the cornerstone of job creation in developed economies. They form the bedrock of subsistence and economic activity in lesser developed countries (LDC). They are the dynamic element of capitalism. SME led by courageous risk takers are the spearhead of capital formation initiatives. Politicians, bureaucrats and business pundits extol their entrepreneurial zeal and hope to channel their youthful energy in service to local and national political aspirations. The establishment of SME is a critical macroeconomic indicator of a country’s economic health and the wellspring of social wealth creation.

The World Bank/ IFC estimates that over 130 million registered SME inhabit the global economy. The definition of an SME varies by country. Generally an SME and MSME (Micro Small Mid Sized Enterprises) are defined by two measures, number of employees or annual sales. Micro enterprises are defined as employing less than 9 employees, small up to 100 employees and medium sized enterprises anywhere from 200 to 500 employees. Defining SMEs by sales scale in a similar fashion.

Every year millions of startup businesses replace the millions that have closed. The world’s largest economy United States boasts over 30 million SME and every year over one million small businesses close. The EU and OECD countries report similar statistics of the preponderance of SME and numbers of business closures.

The SME is a dynamic non homogeneous business segment. It is highly diverse in character, culture and business model heavily colored by local influence and custom. SME is overly sensitive to macroeconomic risk factors and market cyclicality. Risk is magnified in the SME franchise due to high concentration of risk factors. Over reliance on a limited set of key clients or suppliers, product obsolescence, competitive pressures, force majeure events, key employee risk, change management and credit channel dependencies are glaring risk factors magnified by business scale and market geographics.

In the United States, during the banking crisis the Federal Reserve was criticized for pursuing policies that favored large banking and capital market participants while largely ignoring SME. To mitigate contagion risk, The Federal Reserve quickly acted to pump liquidity into the banking sector to buttress the capital structure of SIFI (Systemically Important Financial Institutions). It was thought that a collateral benefit would be the stimulation of SME lending. This never occurred as SBA backed loans nosedived. Former Treasury Secretary Timothy Geithner implemented the TARP and TALF programs to further strengthen the capital base of distressed banks as former Fed Chairman Ben Bernanke pursued Quantitative Easing to transfer troubled mortgage backed securities onto Uncle Sams balance sheet to relieve financial institutions of these troubled assets. Some may argue that President Obama’s The American Recovery and Reinvestment Act of 2009 (ARRA) helped the SME sector. The $800 billion stimulus was one third tax cuts, one third cash infusion to local governments and one third capital expenditures aimed at shovel ready infrastructure improvement projects. The scale of the ARRA was miniscule as compared to support rendered to banks and did little to halt the deteriorating macroeconomic conditions of the collapsing housing market, ballooning unemployment and rising energy prices severely stressing SME.

The EU offered no better. As the PIGS (Portugal, Ireland, Greece, Spain) economies collapsed the European Central Bank forced draconian austerity measures on national government expenditures undermining key SME market sensitivities. On both sides of the Atlantic, the perception of a bifurcated central banking policy that favored TBTF Wall Street over the needs of an atomized SME segment flourished. The wedge between the speculative economy of Wall Street and the real economy on Main Street remains a festering wound.

In contrast to the approach of western central bankers, Asian Tigers, particularly Singapore have created a highly supportive environment for the incubation and development of SME. Banks offer comprehensive portfolios of financial products and SME advisory services. Government legislative programs highlight incubation initiatives linked to specific industry sectors. Developed economies have much to learn from these SME friendly market leaders.

The pressing issues concerning net neutrality, ecommerce tax policies, climate change and the recognition of Bitcoin as a valid commercial specie are critical developments that goes to the heart of a healthy global SME community. These emerging market events are benevolent business drivers for SME and concern grows that legislative initiatives are being drafted to codify advantages for politically connected larger enterprises.

Many view this as a manifestation of a broken political system, rife with protections of large well financed politically connected institutions. Undermining these entrenched corporate interests is the ascending digital paradigm promising to dramatically alter business as usual politics. Witness the role of social media in the Arab Spring, Barack Obama’s 2008 election or the decapitalization of the print media industry as clear signals of the the passing away of the old order of things. Social networking technologies and the democratization of information breaks down the ossified monopolies of knowledge access. These archaic ramparts are being gleefully overthrown by open collaborative initiatives levelling the playing field for all market participants.

SMEIoT

This is where SMEIoT neatly converges. To effectively serve an efficient market, transparency and a contextual understanding of its innate dynamics are critical preconditions to market participation. The incubation of SME and the underwriting of capital formation initiatives from a myriad of providers will occur as information standards provide a level of transparency that optimally aligns risk and investment capital. SMEIoT will provide the insights to the sector for SME to grow and prosper while industry service providers engage SME within the context of a cooperative economic non-exploitative relationship.

This series will examine SME and how IoT will serve to transform and incubate the sector. We’ll examine the typology of the SME ecosystem, its risk characteristics and features. We’ll propose a metadata framework to model SME descriptors, attributes, risk factors and a scoring methodology. We’ll propose an SME portal, review the mission of Big Data and its indispensable role to create cooperative economic frameworks within the SME ecosystem. Lastly we’ll review groundbreaking work social scientists, legal scholars and digital frontier activists are proposing to address best governance practices and ethical considerations of Big Data collection, the protection of privacy rights, informed consent, proprietary content and standards of accountability.

SMEIoT coalesces at the intersection of social science, commerce and technology. History has aligned SMEIot building blocks to create the conditions for this exciting convergence. Wide participation of government agencies, academicians, business leaders, scientists and ethicists will be required to make pursuit of this science serve the greatest good.

This is the first in a series of articles on Big Data and SMEIoT . It originally appeared in Daftblogger eJournal. Next piece in series is scheduled to appear on Daftblogger eJournal within the next two weeks.

Last year lending to small businesses evaporated with glaring exception of Wells Fargo which increased its lending through Small Business Administration (SBA) programs. With bank lending to small businesses nearly frozen many small businesses are scrambling for the credit lines and loans they need to keep their companies alive.

The landscape of lenders willing to provide credit to small business is evolving. Wells Fargo has emerged as the principal provider of credit to the small business market becoming the number-one lender through the SBA loan programs during 2009.

CIT Group, JPMorgan Chase, Banco Popular and Bank of America have cut their SBA lending by more than 70% this year. While Wells Fargo buttressed by its acquisition of Wachovia, increased its loan volume 4%, from $583 million in 2008 to $605 million during 2009.

Wells Fargo acquisition of Wachovia closed three months into the 2009 fiscal year allowing Wells Fargo to book only nine months of Wachovia SBA lending which totaled $742 million a decrease of 24% from aggregate SBA loans extended during 2008. During 2009 the number two lender to small businesses was U.S. Bank which made $250 million in loans through the SBA’s lending program.

The large banking institutions that received TARP funds used that infusion to prop up the capital ratios to improve weak balance sheets. Little of these funds were used to fund credit programs for small businesses. Wells Fargo’s capital ratios were healthier then its larger competitors. This allowed Wells Fargo to take advantage of their rivals distraction from the small business market. Indeed the bankruptcy filing by CIT, the management tremors at Bank of America, Citibank’s scramble for capital and JP Morgan Chase digestion of Bear Stearns allowed Wells Fargo to fill the large vacuum in the neglected SBA lending market.

Wells Fargo also had the advantage of not being dependent on securitizing its SBA loans and selling them in the secondary market. As evidenced by CIT’s bankruptcy filing, funding for securitized loans disappeared as the risk aversion of institutional investors grew and liquidity evaporated from the market. These market events led Wells Fargo to develop a focused discipline on the small business lending market. The bank was committed to closing larger 7(a) SBA loans which are held and managed in the banks loan portfolio. Wells Fargo’s small business strategy discouraged originating SBA Express Loans that offer lower credit limits and tend to have much higher default rates. Wells Fargo’s SBA program and business model should be studied and replicated by community banks to energize small business lending.

Small business lending and capital formation in the sector is a critical component for sustainable economic growth. Banks need to engage the small business market with a deeper understanding of the risks associated with the market. Small business managers must demonstrate to bankers and shareholders that they are worthy stewards of credit and equity capital by implementing sound risk management and corporate governance practices. This assures bankers that small business managers are a good credit risk capable of building a mutually profitable business relationship for the many years to come.

What a difference a year makes. A year ago the banks came crawling to Washington begging for a massive capital infusion to avoid an Armageddon of the global financial system. They sent out an urgent SOS for a $750 billion life preserver of tax payers money to keep the banking system liquid. Our country’s chief bursar Hank Paulson, designed a craft that would help the banks remain afloat. Into the market maelstrom Mr. Paulson launched the USS TARP as the vehicle to save our distressed ship of state. The TARP would prove itself to be our arc of national economic salvation. The success of the TARP has allowed the banks to generate profits in one of the most prolific turnarounds since Rocky Balboa’s heartbreaking split decision loss to Apollo Creed. Some of the banks have repaid the TARP loans to the Fed. Now as Christmas approaches and this incredible year closes bankers have visions of sugar plum fairies dancing in their heads as they dream about how they will spend this years bonus payments based on record breaking profitability. President Obama wants the banks to show some love and return the favor by sharing more of their recapitalized balance sheets by lending money to small and mid-size enterprises (SME).

Yesterday President Obama held a banking summit in Washington DC. Mr. Obama wanted to use the occasion to shame the “fat cat bankers” to expand their lending activities to SMEs. A few of the bigger cats were no shows. They got fogged in at Kennedy Airport. They called in to attend the summit by phone. Clearly shame was not the correct motivational devise to encourage the bankers to begin lending to SMEs. Perhaps the President should have appealed to the bankers sense of patriotism; because now is the time that all good bankers must come to the aid of their country. Failing that, perhaps Mr. Obama should make a business case that SME lending is good for profits. A vibrant SME sector is a powerful driver for wealth creation and economic recovery. A beneficial and perhaps unintended consequence of this endeavor is the economic security and political stability of the nation. These are the worthy concerns of all true patriots and form a common ground where bankers and government can engage the issues that undermine our national security.

The President had a full agenda to cover with the bank executives. Executive compensation, residential mortgage defaults, TARP repayment plans, bank capitalization and small business lending were some of the key topics. Mr. Obama was intent on chastising the reprobate bankers about their penny pinching credit policies toward small businesses. Mr. Obama conveyed to bankers that the country was still confronted with major economic problems. Now that the banks capital base has been stabilized with Treasury supplied funding they must get some skin into the game and belly up to the bar by making more loans to SMEs.

According to the FDIC, lending by U.S. banks fell by 2.8 percent in the third quarter. This is the largest drop since 1984 and the fifth consecutive quarter in which banks have reduced lending. The decline in lending is a serious barrier to economic recovery. Banks reduced the amount of money extended to their customers by $210.4 billion between July and September, cutting back in almost every category, from mortgage lending to funding for corporations. The TARP was intended to spur new lending and the FDIC observed that the largest recipients of aid were responsible for a disproportionate share of the decline in lending. FDIC Chairman Sheila C. Bair stated, “We need to see banks making more loans to their business customers.”

The withdrawal of $210 billion in credit from the market is a major impediment for economic growth. The trend to delever credit exposures is a consequence of the credit bubble and is a sign of prudent management of credit risk. But the reduction of lending activity impedes economic activity and poses barriers to SME capital formation. If the third quarter reduction in credit withdrawal were annualized the amount of capital removed from the credit markets is about 7% of GDP. This coupled with the declining business revenues due to recession creates a huge headwind for SMEs. It is believed that 14% of SMEs are in distress and without expanded access to credit, defaults and bankruptcies will continue to rise. Massive business failures by SMEs shrinks market opportunities for banks and threatens their financial health and long term sustainability.

The number one reason why financial institutions turn down a SME for business loans is due to risk assessment. A bank will look at a number of factors to determine how likely a business will or will not be able to return the money it has borrowed.

SME business managers must conduct a thorough risk assessment if it wishes to attract loan capital from banks. Uncovering the risks and opportunities associated with products and markets, business functions, macroeconomic risks and understanding the critical success factors and measurements that create competitive advantage are cornerstones of effective risk management. Bankers need assurances that managers understand the market dynamics and risk factors present in their business and how they will be managed to repay credit providers. Bankers need confidence that managers have identified the key initiatives that maintain profitability. Bankers will gladly extend credit to SMEs that can validate that credit capital is being deployed effectively by astute managers. Bankers will approve loans when they are confident that SME managers are making prudent capital allocation decisions that are based on a diligent risk/reward assessment.

Sum2 offers products that combine qualitative risk assessment applications with Z-Score quantitative metrics to assess the risk profile and financial health of SMEs. The Profit|Optimizer calibrates qualitative and quantitative risk scoring tools; placing a powerful business management tool into the hands of SME managers. SME managers can demonstrate to bankers that their requests for credit capital is based on a thorough risk assessment and opportunity discovery exercise and will be effective stewards of loan capital.

On a macro level SME managers must vastly improve their risk management and corporate governance cultures to attract the credit capital of banks. Through programs like the Profit|Optimizer, SME’s can position themselves to participate in credit markets with the full faith of friendly bankers. SME lending is a critical pillar to a sustained economic recovery and stability of our banking system. Now is the time for all bankers to come to the aid of their country by opening up credit channels to SMEs to restore economic growth and the wealth of our nation.

The severity of the banking crisis is evident in the 95 banks the FDIC has closed during 2009. The inordinate amount of bank failures has placed a significant strain on the FDIC insurance fund. The FDIC insurance fund protects bank customers from losing their deposits when the FDIC closes an insolvent bank.

The depletion of the FDIC Insurance fund is accelerating at an alarming rate. At the close of the first quarter, the FDIC bank rescue fund had a balance of $13 billion. Since that time three major bank failures, BankUnited Financial Corp, Colonial BancGroup and Guaranty Financial Group depleted the fund by almost $11 billion. In addition to these three large failures over 50 banks have been closed during the past six months. Total assets in the fund are at its lowest level since the close of the S&L Crisis in 1992. Bank analysts research suggests that FDIC may require $100 billion from the insurance fund to cover the expense of an additional 150 to 200 bank failures they estimate will occur through 2013. This will require massive capital infusions into the FDIC insurance fund. The FDIC’s goal of maintaining confidence in functioning credit markets and a sound banking system may yet face its sternest test.

FDIC Chairwoman Sheila Bair is considering a number of options to recapitalize the fund. The US Treasury has a $100 billion line of credit available to the fund. Ms. Bair is also considering a special assessment on bank capital and may ask banks to prepay FDIC premiums through 2012. The prepay option would raise about $45 billion. The FDIC is also exploring capital infusions from foreign banking institutions, Sovereign Wealth Funds and traditional private equity channels.

Requiring banks to prepay its FDIC insurance premiums will drain economic capital from the industry. The removal of $45 billion dollars may not seem like a large amount but it is a considerable amount of capital that banks will need to withdraw from the credit markets with the prepay option. Think of the impact a targeted lending program of $45 billion to SME’s could achieve to incubate and restore economic growth. Sum2 advocates the establishment of an SME Development Bank to encourage capital formation for SMEs to achieve economic growth.

Adding stress to the industry, banks remain obligated to repay TARP funds they received when the program was enacted last year. To date only a fraction of TARP funds have been repaid. Banks also remain under enormous pressure to curtail overdraft, late payment fees and reduce usurious credit card interest rates. All these factors will place added pressures on banks financial performance. Though historic low interest rates and cost of capital will help to buttress bank profitability, high write offs for bad debt, lower fee income and decreased loan origination will test the patience of bank shareholders. Management will surely respond with a new pallet of transaction and penalty fees to maintain a positive P&L statement. Its like a double taxation for citizens. Consumers saddled with additional tax liabilities to maintain a solvent banking system will also incur higher fees by their banks so they can repay the loans extended by the US Treasury to assure a well functioning financial system for the republic’s citizenry.

Reuters reports that the U.S. Treasury will soon launch a new program aimed at aiding small business lending, the head of the Treasury’s $700 billion bailout fund said on Thursday.

Herbert Allison, the Treasury’s assistant secretary for financial stability, declined to provide details or specific timing on the program in testimony before the U.S. Senate Banking Committee.

The US Treasury has focused for the past year on stabilizing the banks with massive capital infusions into the sector with the TARP program. The TARP seems to have succeeded in its goal to shore up the economic capital base of bank’s but lending activity to small and mid-size enterprises (SME) has dramatically slowed. Capital constraints and heightened risk aversion by commercial banks has curtailed access to moderately priced credit products for many SMEs. Credit risk aversion and the recession has hurt the sector and has contributed to growing bankruptcy rates by capital starved SMEs.

SMEs employ more workers then any other business sector demographic. One of the reasons the recession has been so severe is due to the massive layoffs and business closures within the by SME segment. There are approximately 6 million SMEs in the United States. If each SME hired one person that would put a serious dent in the unemployment rate. Some statistics on the SME demographic includes:

• Represent 99.7 percent of all employer firms.
• Employ half of all private sector employees.
• Pay more than 45 percent of total U.S. private payroll.
• Have generated 60 to 80 percent of net new jobs annually over the last decade.
• Create more than 50 percent of non-farm private gross domestic product (GDP).
• Supplied more than 23 percent of the total value of federal prime contracts in FY 2005.
• Produce 13 to 14 times more patents per employee than large patenting firms.
• Are employers of 41 percent of high tech workers (such as scientists, engineers, and computer workers).
• Are 53 percent home-based and 3 percent franchises.
• Made up 97 percent of all identified exporters and produced 28.6 percent of the known export value in FY 2004.

The US Treasury program will target the SME segment and direct capital to help lead the economic recovery. SMEs are the leading source of job creation, product innovation and wealth creation. A vibrant and financially healthy SME sector is key to any sustainable economic recovery. This program will also help to bolster the ailing community banking sector that has seen over 95 closures by the FDIC this year.

It is critical that SMEs prepare to participate in this program. Sum2 offers a complete product suite to help SMEs capitalize on the many opportunities economic recovery will present. Sum2’s recently announced webinar series “Recovery Tools for a New Economy” offers SME critical management tools to profit from the emerging business cycle.

As the lending program to SME rolls out, bankers will initiate engagement process and business reviews. They will be looking to determine if SME managers have identified risks confronting their business. It is incumbent on small business managers to understand how changing market dynamics and operational risk factors are impacting their business and demonstrate how they will mitigate these risk factors.

Sum2 provides a series of risk assessment products that assist companies to chart paths to profitability and growth. The Profit|Optimizer, is a unique risk management and opportunity discovery tool that helps SMEs effectively manage the challenges posed by the recession and recovery business cycles.

The FDIC has reported the failure of 77 banks so far this year. It is the highest rate of bank failures since the height of the Savings and Loan crisis in 1992. The cause of the failure for many of these banks are mounting loan loses on commercial loans made to commercial real estate developers and small and mid-sized businesses (SME). This is dramatically different from the banking crisis that unfolded in the later part of 2008. Bank solvency was threatened due to high default rates in sub-prime mortgage loans and the erosion of value in residential mortgage backed securities (RMBS) held by larger banking intuitions. This led to the TARP program that was created to purchase distressed assets and inject much needed capital into struggling banks.

Most of the bank failures are the result of the macroeconomic factors spawned by the recession. High unemployment and tightening credit availability has stressed many consumer oriented businesses. It has led to alarming bankruptcy rates of SMEs. This has hurt community banks who have a significant portion of their commercial lending portfolios exposed to commercial real estate dependent on a vibrant SME segment. Bank failures remove liquidity from the credit markets. As more banks fail funding sources and loan capital are withdrawn from the system. This is yet another dangerous headwind c0nfronting SMEs as they struggle with a very difficult business cycle.

The FDIC is growing increasingly alarmed about the solvency of its insurance fund and its ability to cover depositors of failed banks. This years largest bank failure, Colonial Bank Group is expected to cost the FDIC insurance fund$2.8 billion. Its a large amount for the stressed fund to cover in light this years high number of bank failures and an expectation that failures will continue to rise.

According to Forbes online, the FDIC has indicated concern that the Guaranty Financial Group Inc., a Texas-based company with $15 billion in assets that racked up losses on loans to home builders and borrowers in California, and Corus Bankshares Inc., a $7 billion Chicago lender to condominium, office and hotel projects are also at risk of failing. Each failure will place a added strain on the FDIC insurance fund. The costliest failure was the July 2008 seizure of big California lender IndyMac Bank, on which the fund is estimated to have lost $10.7 billion.

The FDIC expects bank failures will cost the fund around $70 billion through 2013. The fund stood at $13 billion – its lowest level since 1993 – at the end of March. It has slipped to 0.27 percent of total insured deposits, below the minimum mandated by Congress of 1.15 percent.

The FDIC has a huge challenge on its hands. It needs to maintain the orderly working of the banking system to alleviate the waning confidence of consumers and shareholders. Recently it was announced that restrictions on private equity firms purchasing banking companies will be relaxed to assure that the industry remains sufficiently capitalized. Regulators will need to increase oversight of community banks risk management controls. The added transparency may be resented by bank management but it may help to stem the tide of accelerating bank failures as the difficult conditions in the commercial real estate market persists. In any case bankers should expect to see an increase in FDIC insurgence premiums to recapitalize the depleted fund. Unfortunately bank customers will be burdened with rising fees banks charge for services as they seek ways to cover the rising expense of default insurance.

Bankers must become more vigilant in their assessments to determine the credit worthiness of SMEs. Sum2’s Profit|Optimizer is helping bankers assess small business credit worthiness; leading to lower loan defaults, higher profitability and more harmonious client relationships. The Profit|Optimizer is also available for purchase on Amazon.com.

An article in today’s Forbes online entitled Trouble with TARP, reports a growing concern by the Congressional Oversight Panel (COP) about the effectiveness of the $700 billion program. The COP reports that the effectiveness of the program is difficult to determine due to lack of transparency of how funds were spent. The COP report also states that the absence of any reporting guidelines for TARP participants impedes effective oversight.

The 145 page report starts with a retelling of the extreme conditions confronting the banking sector as the credit crisis exploded last autumn. It also outlines the choices confronting regulators, legislators and industry executives as the crisis deepened. We were led to believe by Treasury and Federal Reserve officials that the global banking system was in imminent danger of collapse. Nothing less then immediate and drastic measures taken by sovereign government officials and industry executives would prevent the catastrophic consequences of global economic carnage. The report makes it clear that these market conditions were so extreme that regulators were navigating through uncharted waters. Any remediation measures taken had little historical precedence to guide actions. Hence Paulson was given carte blanche to handle the crisis with unprecedented latitude and executive facility.

As this blog reported earlier this week, the TARP was originally designed to acquire troubled assets from banking institutions. TARP funds were earmarked to purchase mortgage backed securities and other derivatives whose distressed valuations severely eroded capital ratios and stressed banks balance sheets. Hank Paulson later shifted the strategy and decided to inject TARP funds into the banks equity base. This has done wonders for the shareholders of the banks but troubled assets remain on the banks balance sheet. As the recession continues, unemployment, home foreclosures, SME bankruptcies and the looming problem with commercial mortgage backed securities (CMBS) are placing a new round of added strain on the banking system.

The TALF program is designed to draw private money into partnership with the government to acquire troubled assets from banks. So far the program has received a tepid response. I suspect that the principal factors inhibiting the expansion of the TALF program are numerous. Chief among them is the inability of FASB to decide upon valuation guidelines of Level III Assets. Banks holding distressed securities may also be reluctant to part with these assets because they have tremendous upside potential as the economy improves.

The COP also questioned the effectiveness of TARP because stress tests were only conducted on 19 banks. The report states that additional stress tests may be required because the previous tests failed to account for the length and depth and length of the recession. Community banks are also of concern. They face a perfect storm in challenging macroeconomic conditions. Of particular concern is commercial real estate loans. Many economists are concerned that high rate of loan defaults in commercial loan portfolios pose great threats to the community banking sector.

Though interest rates remain low due to the actions of the Federal Reserve, lending by banks still remains weak. SME’s are capital starved and bankruptcy rates are quickly rising. SME’s are critical to any economic recovery scenario. A strong SME sector is also crucial for a vibrant and profitable banking system. Perhaps a second round of TARP funding may be required to get more credit flowing to SME’s. If banks start failing again it would be devastating. The Treasury and the Federal Reserve don’t have many bullets left to fire because of all the previous expenditures and a waning political will of the people to continue to fund a systemically damaged banking system.

According to a recently published report by a Congressional Oversight Panel reviewing the effectiveness of the Troubled Asset Relief Program (TARP), many banks remain vulnerable due to questionable commercial loans still held on their balance sheets. This is a looming problem for community and smaller banking institutions. Smaller banks are being adversely effected by the the rise of commercial loan defaults. Many community banks have large loan exposures to shopping malls and other small businesses hard hit by the recession.

The report states, “Owners of shopping malls, hotels and offices have been defaulting on their loans at an alarming rate, and the commercial real estate market isn’t expected to hit bottom for three more years, industry experts have warned. Delinquency rates on commercial loans have doubled in the past year to 7 percent as more companies downsize and retailers close their doors, according to the Federal Reserve.

The commercial real estate market’s fortunes are tied closely to the economy, especially unemployment, which registered 9.4 percent last month. As people lose their jobs, or have their hours reduced, they cut back on spending, which hurts retailers, and take fewer trips, affecting hotels.”

Defaults in sub prime and other residential mortgages precipitated last years banking and credit crisis. The TARP program succeeded in stabilizing a banking system that was teetering on collapse. The $700bn infusion into the banking system appears to have buttressed depleted capital ratios and severely stressed balance sheets of large banking institutions. But many banks are still carrying troubled assets on their balance sheets. Commercial Mortgage Backed Securities (CMBS) values are tied to the cash flows generated by renters and lessors of the underlying mortgaged properties. As occupancy rates of commercial properties fall cash flows dissipate. The market value of these securities plummets creating a distressed condition. This places additional strain on the banks balance sheet driving capital ratios lower and places a banks liquidity and ability to lend at risk.

The TALF (Term Asset Backed Loan Facility) was instituted in March to extend $200bn in credit to buy side financial institutions to purchase troubled assets and remove them from banks balance sheets. So far only $30bn has been allocated through the program. Clearly banks balance sheets remain at risk due to their continued high exposure to this asset class.

A strong economic recovery will address this problem. A prolonged recession will resurrect the banking and credit crisis we experienced last autumn. It would appear that TARP II may be a necessity if more private sector investors don’t step up to the plate and participate in TALF.

President Obama announced his intention to curb the use of offshore tax havens for multinational corporations. The Treasury Department is looking to raise tax revenues and believes that by closing the use of offshore tax shelters it will be able to raise over $200 bn over the next ten years. According to the New York Times, firms like Citibank, Morgan Stanley, GE and Proctor and Gamble utilize hundreds of these type structures to shelter revenue from being taxed by the IRS. It has effectively driven down the tax rates these companies pay and has been a key driver in maintaining corporate profitability.

This move should come as a surprise to no one. The Treasury Department needs to find sources of tax revenues to cover the massive spending programs necessitated by the credit crisis and the global economic meltdown. The TARP program designed to revitalize banks has expenditures that amounted to $700 bn. Amounts pledged for economic recovery through EESA, PPIP and ARRA will push Treasury Department expenditures targeting economic stimulus projects and programs to approximately $2 tn. These amounts are over and above routine federal budget expenditures that is running significant deficits as well.

The planned move by the Treasury Department to rewrite the tax code may be an intentional effort to close budget deficits but it also represents a significant rise in tax audit risk. For the past two years the IRS has been developing a practice strategy and organizational assets to more effectively enforce existing tax laws. Private sector expertise, practices and resource has significantly out gunned the IRS’s ability to detect and develop a regulatory comprehension of the tax implications of the sophisticated multidomiciled structured transactions flowing through highly stratified and dispersed corporate structures. The IRS is looking to level the playing field by adding to its arsenal of resources required to engage the high powered legal and accounting expertise that corporate entities employ.

The IRS has hired hundreds of new agents and has developed risk based audit assessment guidelines for field agents when examining corporations with sophisticated structures and business models. As such investment partnerships, global multinational corporations and companies utilizing offshore structures can expect to receive more attention from IRS examiners.

The IRS had developed Industry Focus Issues (IFI) to be used as an examination framework to guide audit engagements for sophisticated investment partnerships and Large and Mid-size Businesses (LSMB). The IFI for LSMB has developed three tiers of examination risk. Each tier has comprises about 12 examination issues that will help examiners focus attention of audit resource on areas the agency considers as high probability for non-compliance. Clearly the audit risk factors risk

To respond to this challenge, Sum2 developed an audit risk assessment program to assist CFO’s, tax managers, accountants and attorneys conduct a through IFI risk assessment. The IRS Audit Risk Program (IARP) is a mitigation and management tool designed to temper the threat of tax audit risk. A recent survey commissioned by Sum2 to measure industry awareness of IFI risk awareness indicated extremely low awareness of tax audit risk factors.

The IARP links to all pertinent IRS documentation and information on each tax statute and IFI audit tier. The IARP links to pertinent forms and allows for easy information retrieval and search capabilities of the vast IRS document libraries. The IARP also has links to FASB to have instant access to latest information on accounting and valuation treatments for structured instruments.

The IARP is the newest risk application in the Profit|Optimizer product series. The Profit|Optimizer is a enterprise risk management tool used by SME’s and industry service providers.

Interesting piece at CFO Magazine concerning fair value deterioration of Level Three Assets at Goldman Sachs during the month of August. Goldman Sachs reports that valuation of Level Three Assets dropped by 13%. It would be interesting to understand the impact of this collateral erosion had on GS’s largest counter-party AIG?

Was this the trigger that precursors the radical interventionist moves by the Treasury to purchase a controlling stake in AIG?

This insight will become most constructive as the Treasury begins its purchase program of toxic level three assets. Hammering Hank has hired Neel Kashkari one of his mentees from GS to head up the repurchase program. Mr. Kashkari is said to be a quantitative wiz kid and a real life rocket scientist to buy Level Three Assets from GS and other banks and create and manage a portfolio of toxic assets on behalf of the American taxpayers.

About

Sum2llc is a company sponsored blog of Sum2. The purpose of sum2llc is to assist SME’s and the industries that serve them implement sound business practices to build profitability and maintain sustainable growth.

Sum2 is dedicated to the commercial application of sound practices.

Sum2’s sound practices program and products address:

* corporate governance

* risk management

* stakeholder communications

* regulatory compliance

Sum2 believes that all enterprises enhance their equity value by implementing a sound practice program. Sound practices are principal value drivers for corporate and product brands. Practitioners are awarded with healthy profit margins, attraction of high end clientele, enterprise risk mitigation and premium equity valuation.

Sum2 looks forward to helping you address the pressing challenges of the current business cycle.